Dovish Bernanke Punishes the Dollar

Bernanke's remarks this morning on the US job market are being considered his most dovish stance to date. The “reserve currency of choice” has managed to penetrate the overnight Asian highs, triggering stop losses and currently resides north of the psychological 1.33 level. However, unless the market gets a sense that the Fed is contemplating another round of QE then the dollar is not expected to weaken significantly from here. PIMCO on the other hand says the Fed may hint at QE3 in April.

The dollar has been sold off first thing in North America as the market focuses on Bernanke's statement that improvements in the job market will require faster economic growth, “a process that can be supported by continued accommodative policies.” But, what does he mean by “continued accommodation”? It's this phrase that is very much open to interpretation. It could mean either a delay in their exit strategy of current policy or hiking the Fed's fund target. The FI dealers could argue that policy makers are “not comfortable with the twist's expiration at the end of June,” heightening speculation of introducing QE3. It's not in the Fed's mandate to be so explicit about their future actions. All he has done is “doubt the sustainability of further material improvement in job markets going forward.” However, rationally investors will be forming a biased opinion.

By stating that the problems troubling the job markets are ‘cyclical and not structural' he is saying that policy stimulus can be effective at reducing labor market slack. If however, the problems facing the US were structural in nature, then accommodative monetary policy would not necessarily be effective. He is indicating that it's a demand problem that can be fixed with accommodation. Bernanke also notes that the improvement in job markets to date has not been demand driven, and mentions a number of measures to the effect that the pace of improvement is disappointing. He indicates that “further significant improvements in unemployment will likely require faster economic growth than we experienced during the past year.” In fact, he is playing into the majority of investors ‘who believe in reverting back into the low yield environment by an ever growing series of QE's.” If one reads carefully, so not so.

Later today, the Fed is scheduled to sell Treasury securities for its stimulus plan that extends the average maturity of the US government debt on its balance sheet. They plan to sell between $8b and $8.75b short dated notes, a part of its Operation Twist accommodation effort. By purchasing longer dated securities, policy makers hope to push longer dated yields lower for consumers and business to facilitate economic recovery. So far this morning, US 10's have backed up +1.5bp to +2.24%